In the days before they were gung ho about the need for spending cuts, the Liberal Democrats used to be equally gung ho about the need for Britain to join the single currency. Indeed, Danny Alexander, the Treasury minister wielding the spending axe, was the spin doctor for Britain in Europe, the pressure group dedicated to seeing that the pound was scrapped.

To be fair, Alexander was not alone. All the other Lib Dem big guns – Nick Clegg, Chris Huhne, Vince Cable – were as insistent then that failure to join monetary union would be an error of historic proportions, as they are insistent now that there is no alternative to austerity.

Given that the coalition was forged in early May, when the eurozone was embroiled in a colossal crisis, it is perhaps unsurprising that membership of the single currency has been ruled out for this parliament. By which time, there may no longer be a euro to join.

While UK politics has been dominated by the deficit these past four months, the crisis in the monetary union has not gone away. Events came to a head in the spring, when the European Union and the International Monetary Fund organised a bailout for Greece amid extreme market turbulence. The markets calmed down for a while, but pressure gradually built up again. By early this month, the evidence of distress was as powerful as it had been in the spring.

One key indicator of trouble is the difference between the interest rate on German bonds and the interest rate on bonds issued by other governments in the eurozone. When this gap – or spread – is narrow, it means that bonds of, say, Greece or Ireland are considered almost as safe as those in Germany. When the spread widens, it is a sign that investors are getting nervous.

The worrying news for governments in Athens, Lisbon and Dublin is that bond spreads are back to where they were in early May, despite the €750bn (£627bn) bailout. The reason is simple: financial markets do not believe the lines of credit solve the underlying problem, which is that the debts of the weaker eurozone countries are unsustainable without much stronger economic growth. And the flawed structure of the eurozone makes stronger economic growth unachievable. The upshot, as even supporters of the single currency now admit, is that the whole project is at risk.

What has happened is this. Joining the single currency involved countries pooling their monetary policies, jettisoning the right to set their own interest rates or alter their exchange rates, and adopting a common 2% inflation target.

But in a common currency zone, differences in economic performance are quickly magnified. If labour costs in country A rise by 1% a year on average for 10 years while labour costs in country B rise by 5% a year on average, country B becomes less and less competitive and its trade deficit will widen.

Trade deficits have to be financed, so capital flows into the debtor nations. If interest rates are low, the inflows of "hot money" lead to speculation and asset price bubbles. When the bubbles burst, the credit dries up.

This is precisely how events in the eurozone have unfolded. Country A above is Germany; country B could be any country on the periphery of the eurozone. Germany has driven down labour costs, becoming more and more competitive at the expense of its neighbours. It exported the capital that fuelled the asset price bubbles. Countries such as Greece built up huge stocks of both private and public debt. Yet, once the crisis broke, the lines of credit were turned off.

It would be wrong, though, to imagine that it has only been the weaker nations that have been hurt by Germany's beggar-my-neighbour policy. In its annual trade and development report last week, Unctad illustrated the difference between real wages and unit labour costs in Germany and France over the past decade. By bearing down on wages and unit labour costs, Germany has opened up a 20% competitiveness gap with its big neighbour. "Wage restraint was beneficial for the German economy only in terms of boosting its international competitiveness and exports, an effect that was supported by Germany's membership of the European currency union," said the report.

"However, inside the euro area, the effects of German wage restraint on the country's real exchange rate and external trade are being felt in many countries in the form of current account deficits. This is causing a deflationary threat for the currency area as a whole, because sooner or later wage restraint will become unavoidable in the deficit countries, especially Greece, Portugal and Spain."

To make matters worse, Germany has proved resistant to the idea that it should boost its own domestic consumption and thereby help the weaker nations export their way out of trouble. As Alistair Darling noted at last week's Anglo-German conference in Königswinter, Berlin has failed to accept the leadership role that its economic pre-eminence requires.

Following Germany's lead in committing to fiscal consolidation to regain market confidence, fiscal austerity is set to spread across the continent in 2011. With the prospect of a premature end to stimulus policies in Europe, there is growing fear of a possible European, or even global, double-dip recession occurring.

So what happens now? The man responsible for the Unctad report was Heiner Flassbeck, formerly right-hand man to Oskar Lafontaine and a strong supporter of monetary union when it was being established. He believes the current policy regime in the eurozone is unsustainable.

Simon Tilford, the chief economist at the Centre for European Reform, thinks similarly. Another supporter of the idea of a single currency, Tilford published a scathing critique last week of the current state of the eurozone, warning that it could easily break up.

Like Flassbeck, Tilford is concerned about the deflationary bias of policy. "The eurozone can only avoid permanent crisis by convincing investors that growth will be strong enough for the hard-hit members of the currency union to service their debts," he said. "As things stand, it is hard to see how they can grow their way out of trouble. They need a big external stimulus to offset budget cuts and falls in real wages at home: their exports need to grow faster than their imports for a lengthy period."

Tilford believes Europe needs a much higher degree of political and economic integration but is unlikely to get it. He is almost certainly right. There is no appetite for it in Europe's capitals and no appetite for it among voters.

On the contrary, what we are seeing is a race to the bottom. Every country is being urged to tighten fiscal policy and every country is being forced to emulate Germany's downward pressure on labour costs. This is the recipe for deflation and depression.

And that explains why joining the single currency is not high on the agenda at this week's Lib Dem conference. The deep structural flaws in monetary union, which were always there for those not starry-eyed about "the Project", have been brutally exposed.

The fact that Clegg et al were so spectacularly wrong about the euro does not, of course, mean that they are necessarily wrong about the need to impose the deepest spending cuts since the 1920s. But they do have form.